Microsoft’s most important new project in 25 years started out as an unmitigated disaster.

It was 2007. A group of executives gathered in a boardroom on the company’s Redmond campus to watch a rough concept video of how Microsoft was going to regain its mojo in video gaming. With the company’s crash-prone Xbox 360 platform starting to show its age, a team proposed to leapfrog Nintendo’s motion-controlled Wii system—players would go controller-free, using only their body motions and voices to interact with the console. The man with the highest stake in the session was the newly appointed president of interactive entertainment—Don Mattrick, a Canadian video game wunderkind now facing the biggest test of his career.

To convey the concept, the team working on Project Natal had split the screen. Bad sign. Humans live in one reality, not two. On one side of the screen played footage from a traditional car-racing game. On the other side was an actor pretending to turn a virtual steering wheel. Except he looked like he was trying to open a bank vault while having a seizure.

The presentation went over like a lead balloon—and Mattrick realized he and the team working on what came to be called Kinect had to start over.

“That’s what happens when you take a bunch of core game designers and just sit in a room coming up with ideas that you think are going to be broadening, with little to no understanding of your customer,” Kinect creative director Kudo Tsunoda said this summer, looking back on the false start. Instead of just being video game designers, the Kinect team had to start thinking like regular human beings.

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It was by no means certain that Microsoft could travel from that pivotal meeting to Kinect’s current status as the fastest-selling electronic device in the world. The company’s genes didn’t augur well. As a popular org-chart spoof has it on the Web, Microsoft can resemble a set of distinct fortresses, each one poised to take shots at the others.

Yet Microsoft actually was ahead of most of its competitors in seeing the potential of video games to grow up, and even define the future of computing. But the company couldn’t capitalize on the insight.

The original Xbox console, launched a decade ago, was designed to entrench Microsoft in the living room. The idea was ambitious but simple: Your Xbox would be the one device you turned to for entertainment, whether you wanted to stream a movie from your home computer or play a video game. That goal was so alluring that Microsoft didn’t mind losing money every time it sold an Xbox, just so long as it got in the living-room door.

But the strategy wasn’t working. For one thing, new offerings from Sony and Nintendo (the PS3 and Wii consoles, respectively) were eating up growing chunks of the market.

There were also technical glitches. By 2007, the Xbox was best known to many consumers not as the Swiss Army knife of digital entertainment, but as a technical train wreck. Users frequently complained of the “red ring of death”—a trio of lights that, once it appeared around the console’s power button, indicated the Xbox’s insides had pretty much exploded, and the console was now, in electronics parlance, “bricked.” Microsoft eventually took a $1-billion charge on warranty extensions and replacements, to say nothing of the public-relations cost and the eventual fix (all currency in U.S. dollars).

To complicate matters, the video game industry is a fast and fickle one, where success can be as fleeting as a newbie’s first play. Consider a recent example: Guitar Hero, the hit game in which participants “play” on a guitar-shaped controller. In 2007, Activision sold 1.5 million units of the then-current Guitar Hero title in its first month on the U.S. market. In 2010, that number dropped to less than 100,000 for a newer iteration. This year, Activision put the title on hiatus.

The same pattern holds for consoles. Even the Wii, the bestselling home gaming console of its generation, has seen waning sales for the past few years, forcing Nintendo this year to announce the development of a brand-new console.

But as that initial generation of motion-controlled games began to take hold in the mid-2000s, Microsoft executives knew that if they were to gain supremacy in the gaming market, they would need something future-proof, something that would buy the Xbox a few more years of good sales before Microsoft, too, would be forced to spend billions on a brand-new console.

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